When I bring up the merits of a globally diversified portfolio, my clients are quick to ask, “How have foreign stock funds done recently compared to U.S. stock funds?”
“Not well,” I sheepishly answer.
Over the past decade, the S&P 500 has returned a robust 14.6 percent per year. That blows away the 7.5 percent annual return of European stocks and the 6.3 percent return posted by emerging markets, according to Morningstar.
With the bad news out of the way, you can make a conversational pivot with clients. A decade of massive outperformance means that U.S. equities are now very richly-valued compared to global peers.
At the end of the first quarter, U.S. stocks were valued at 19.6 times trailing earnings, according to Germany’s Star Capital. That multiple drops to 16.5 for European stocks and 13.9 for emerging markets. And that may hold the key to future relative returns.
“The U.S. will not outperform forever, and a lot of it comes down to valuations,” says Jeremy Schwartz, the global head of research at WisdomTree Asset Management.
What Price Growth?
To be clear, making the case for European equities with slightly lower P/E ratios can be hard in the face of anemic economic growth on the Continent. The U.S. economy has been growing faster than its Euro-based rivals for an extended period, and few economists expect a role reversal any time soon.
Yet in a May 2019 note to clients, strategists at Franklin Templeton wrote that “European stocks are priced to reflect too much pessimism,” adding that “European equities are currently the cheapest in decades relative to the United States on a price-to-book basis, and the region is the cheapest since the sovereign debt crisis a decade ago on a price-to-earnings basis.”
For example, the average holding in the Vanguard FTSE Europe ETF (VGK) is valued at 1.6 times book value and 1.1 times sales. Those multiples for the S&P 500 are 3.1 and 2.1, respectively. In effect, the U.S. market is roughly twice as expensive by those metrics. The fund has $13.4 billion in assets and a very low 0.09 percent expense ratio.
Cheaper And Faster
The contrast between the U.S. and emerging markets is even clearer. Not only are emerging markets vastly cheaper by a range of measures, their economies are in the midst of the kind of long-term consumer-led expansion the U.S. experienced after World War II.
In 2010, emerging markets accounted for just $12 trillion (or 31 percent) of global consumer spending. By 2025, such spending should surge to $30 trillion, or 47 percent of global consumption by that time, according to McKinsey & Co.
“Demographics and valuations suggest that emerging markets should have a meaningful weighting in investors’ portfolios,” says Schwartz.
Yet this may be where advisors drop the ball in terms of targeted exposure to emerging markets. Most clients get their emerging markets exposure through the category’s largest funds such as the Shares MSCI Emerging Markets ETF (EEM), SPDR Portfolio Emerging Markets ETF (SPEM) and the Vanguard FTSE Emerging Markets ETF (VWO). Trouble is, such funds primarily focus on large companies like Samsung, Vale and Taiwan Semiconductor that are more levered to developed-market growth dynamics than emerging-market trends.